Banking and Finance 1

COMMERCIAL BORROWERS
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Terms in this set (28)
COMMERCIAL BORROWERS
1. Governments
2. Local Authorities and municipalities
3. Companies
4. Partnerships
5. Sole Traders
6. Educational institutions
7. Supranational organisations
Financing a company
1. Share capital
2. Retained profits
3. Loan Facilities
4. Capital Markets Instruments
Lenders
1. Banks
- Commercial Banks
- Investment banks
- Central banks
- Universal banks
2. Institutional lenders
3. Individuals
Investment grade Loan
where the borrower is typically a large established company requiring cash to run and expand its business, and possibly make small acquisitions;
Leveraged Loans
where the amount of debt is substantial compared to the borrower's earnings and/or its share capital (equity). Because this involves greater risk for a bank, the controls in the facility agreement are usually tighter. Leveraged loans are usually used for 'acquisition finance' in which companies, or private equity funds, buy other companies or groups
cross-over credit
where a borrower is borderline investment grade and so subject to controls in the facility agreement stricter than usual investment grade loans but not usually as strict as leveraged loans.
The format and scope of the investigation will vary with the identity of the bank and the borrower as well as a number of factors, including
(a) the size of the loan;
(b) the type of loan and its purpose;
(c) whether the loan is to be secured;
(d) whether the borrower is already known to the bank;
(e) market liquidity (ie, whether there are numerous or few lenders willing to lend); and
(f ) whether the loan is an integral part of a larger transaction, such as a flotation or an acquisition (where the due diligence process will have to take account of the larger transaction).
Ongoing information
It is important to realise that a bank's information gathering does not end with the signing of the loan document. A bank must monitor the borrower to ensure it has a reasonable chance of getting its loan repaid. This is the practical reason behind the repeated representations and undertakings in a facility agreement
Acquisition finance
The position is different here. Traditionally, acquisition financings involve greater due diligence since they are leveraged financings with increased risk. However, in very liquid markets, with multiple bidders for each target company, due diligence may be very limited. In particular, if the target is already owned by a private equity house, due diligence may consist of just a few documents and reports about the target company made available to view for a limited time in a 'data room' (either a 'virtual' data room - ie, online - or a designated room at the vendor's solicitor). In a hostile acquisition of a public company, information will also be limited.
Term Sheet and Commitment Letter
A term sheet is a document which records, in writing, the principal terms of a transaction. It is signed by the parties to the transaction, but it is not usually intended to be contractually binding
Term sheets are often attached as an Appendix to a short letter (the 'commitment letter' or 'mandate letter'), which contains any legally binding terms required at the outset of the lending process
WHAT SHOULD THE COMMITMENT LETTER COVER?1. Banks obligation to arrange the facility is best efforts or underwritten 2. Any general conditionality to the offer to arrange 3. A material adverse change provision, allowing the bank to withdraw from the offer if there is a material adverse change to the market generally 4. A clear market clause 5. A market flex 6. Provisions for the bank to recover fees.Walford and Others v Miles and Another [1992] 2 AC 128).The commitment letter and term sheet are usually intended to set parameters for negotiating the facility agreement. There is no implied duty to negotiate in good faith under English law (although many other European jurisdictions do imply some sort of duty): in other words, either party may withdraw at any time without reason. There is also long-established authority that even an express contractual obligation to negotiate in good faith would be unenforceable for lack of certaintyOverdraft1. Uncommitted, on demand facility. Must be repaid whenever the bank demands. An overdraft is a relatively expensive way of borrowing capital. Interest is calculated on the amount outstanding each day, and usually charged at a fixed percentage above the bank's base rate. The bank will also charge a relatively high fee for providing an overdraft, since it requires more administration than other loan facilities.Term LoanA term loan (or 'term facility': both labels are used for this type of credit) essentially provides a specified capital sum over a set period (the 'term'), with an agreed schedule for repayment. Term loans provide a borrower with a lump sum of capital usually for a specified purpose, for example setting up a business, renewing assets ('capital expenditure'), or acquiring another business. Committed. Repayable in an agreed timetable. Term loans are not usually 'on demand': the bank cannot withdraw the facility unless the borrower defaultsRevolving credit facility1. Like a term loan, a revolving credit facility (RCF) provides a maximum aggregate amount of capital, available over a specified period. Unlike a term loan, the RCF allows a borrower to draw down and repay tranches of the available capital, almost as and when it chooses throughout the term of the loan The RCF combines some of the flexibility of an overdraft, allowing the borrower to draw money when it is required, with the certainty of a term loan (the RCF is usually a committed facility: see 3.2). Not only can the borrower save money by not drawing the whole loan at once, it can also elect to repay outstanding tranches that it no longer requires. Interest payments can therefore be kept to a minimum. Like an overdraft, the RCF is a 'working capital' facility intended to meet the short-term, fluctuating capital needs of the borrower.Committed or uncommitted facilitiesA facility is committed if the facility agreement, once executed, obliges the bank to advance monies at the borrower's request If the facility agreement allows the bank some discretion before advancing any loan monies, the facility will be an 'uncommitted' facilityArrangerThe arranger (sometimes known as the 'mandated lead arranger' or 'MLA') is the bank responsible for advising the borrower as to the type of facility it requires, finding other banks to form the initial syndicate (known as 'primary syndication'), and negotiating the broad terms of the loan. It will either be a bank with which the borrower already has a relationship or one which has won the mandate to arrange the loan after pitching for the role. In large facilities there may be several arrangers.Administrative agenta) the agent will not want any obligation to act unless instructed by the syndicate; (b) the agent will want the ability to delegate its functions and to take professional advice if necessary; (c) the agent will want syndicate members to take responsibility for their own credit assessment of the borrower. It will not want responsibility for any information it passes to the syndicate members with respect to the borrower, for the efficacy of the facility agreement, or for any security or other ancillary documents (see 3.3.4 below); (d) syndicate members will also be required to complete their own 'Know Your Customer' (or 'KYC') checks to comply with money laundering regulations; (e) the agent must be permitted to take an agency fee, as well as an indemnity for costs, losses and liabilities, from the borrower; (f ) to the extent that costs, losses and liabilities are not recovered from the borrower under(e) above, the agent will want an indemnity from the syndicate; (g) the agent will always want a right to resign and the syndicate will want the right to replace it. This will entail provisions dealing with notice periods and the procedure for appointing a successor (either by the agent or by the majority lenders depending on the circumstances). Whilst the agent is agent to the syndicate, the borrower is usually given consultation rights on any replacement because the relationship between them is so importantMATCHED FUNDINGBefore exploring loan facilities further, it is important to understand a concept that permeates many of the mechanics clauses. Most facility agreements assume that when the borrower requests a utilisation, say for £10 million, the facility banks will fund their commitment by borrowing £10 million from other banks in the London interbank market. This is known as 'matched funding'.FACILITY AGREEMENT1. Date, title and parties 2. Interpretation 3. Operative provisions 4. Schedules 5. ExecutionPURPOSE CLAUSEThe bank will want the facility agreement to state explicitly how the loan monies can be used. It is the first point of control which a bank can use to protect its money and maximise the probability of being repaid. Banks will want to ensure that the borrower has unrestricted capacity ('power') to borrow under the facility and, where required, to give a guarantee and/or security As well as ensuring the borrower has capacity, the bank must be sure that whoever executes the facility agreement and any other documents on behalf of the borrower has authority to do so. Typically the borrower's directors will approve the transaction in a board meeting and will execute the relevant documents.CONDITIONS PRECEDENTConditions precedent (CPs) are, as their name suggests, specific conditions which a bank requires a borrower to fulfil before part or all of a facility agreement takes effect. The CPs provide tangible evidence that the representations and warranties (see Chapter 5) are met.AVAILABILITYThe availability or 'utilisation' clause deals with the mechanics of when and how the borrower can actually borrow money under the facility. A simple term loan facility might allow the money to be utilised in one amount on a specified day. The utilisation clause will essentially say: satisfy the CPs, repeat the representations, and so long as you are not in default we will comply with your utilisation request.FLOATING RATE INTERESTBanks are intermediaries and so the interest they charge on their loans must cover their cost of raising money as well as an element of profit to keep their shareholders happy. The majority of commercial loans will bear interest at a floating rate: the interest rate will vary through the life of the loan to reflect the fluctuating cost to the bank of raising money in the market. Floating rate loans are usually based on 'base rate' or more commonly an Interbank Offered Rate (IBOR), and these concepts are explored below.LIBOR a floating rate is usually the sum of two elements:(a) LIBOR (or equivalent): representing the main cost of funding (see 3.8 and below); and (b) margin: generating the bank's profit and covering regulatory capital costsINTEREST PERIODSa) the chosen interest period will (theoretically at least) be mirrored by the bank's interbank loan (the borrower's choice is often limited to one, three or six months, since these are the most common interbank funding periods); (b) the LIBOR rate is recalculated at the start of each interest period and applies for the duration of that interest period (hence the 'floating rate' loan is really a succession of different fixed rates); (c) interest is payable at the end of each interest period; (d) the borrower can usually select the duration of each interest period, giving it some control over the rate it pays and timing of payment to match income; (e) repayments (and prepayments) are required to coincide with the end of an interest period, when the bank will (theoretically) be repaying its interbank loan. If the borrower prepays mid interest period, it will be charged 'break costs'. These are typically the difference between total interest the bank would have received to the end of the broken interest period, less the interest it can raise by lending the prepaid amount in the nterbank market. Strong borrowers will argue they should not pay margin or mandatory cost for the remaining period but just the difference between the LIBOR on the loan and the current LIBOR (if less); and (f ) some of the representations will be repeated on the first day of each interest period.RATCHETSSome facility agreements provide for their margin to vary in accordance with the health of a borrower, which is measured through monitoring its financial ratios (for cross-over or leveraged facilities) or credit rating (for investment grade facilities) (see 17.11). These 'margin ratchets' are intended to reflect the variation in risk borne by the bank, and provide an incentive for the borrower to perform well. If the ratios (or rating) worsen, the margin increases; if they improve, the margin falls and the loan is 'cheaper'.HEDGINGWhile most commercial loans will carry floating rate interest, this does leave borrowers vulnerable to upward swings in the floating rate on which they are based (eg LIBOR). This is particularly acute for leveraged borrowers, which typically have large loans with relatively high margins. Many leveraged borrowers therefore manage ('hedge') their exposure to interest rate fluctuation by entering into an interest rate swap (a type of derivative). Essentially, the borrower contracts to periodically pay a fixed amount to another party (the 'counterparty') in return for an amount which varies in line with the floating rate of interest under the loan facility. The borrower therefore knows (and can budget for) its fixed obligations under the swap whilst also knowing it will receive income from the counterparty to meet its floating rate obligations under the loan.